Cheap Oil Also Means Cheaper Commodities Amid Surpluses

Source: By Isaac Arnsdorf, Bloomberg • Posted: Tuesday, December 9, 2014

Photographer: Luke Sharrett/Bloomberg. A farmer uses a combine to harvest corn in Shelbyville, Kentucky, U.S.

Lower fuel prices are compounding the longest commodity slump in a generation.

Because energy accounts for as much as half the cost to produce food and metals, all sorts of commodities will keep dropping, according to Societe Generale SA and Citigroup Inc. With inventories ample and slowing economies eroding demand, cheaper oil lowers the price floor for mining companies and farmers to remain profitable. Corn may drop another 3 percent, cotton 6.5 percent and gold as much as 5 percent, SocGen estimates.

Costs are falling as surpluses emerge in copper and sugar and as the economy slows in China, the top consumer of energy, metals, pork and soybeans. The Bloomberg Commodity Index of 22 items is heading for a fourth straight annual drop, the longest slump since its inception in 1991. Brent crude, gasoline and heating oil are the biggest losers as an increase in U.S. drilling led to a price war with producers in OPEC.

“There’s been a structural change in oil, and there’s more to come,” said Michael Haigh, the head of commodities research at Paris-based SocGen. “This will also ripple through other commodity markets, in some cases directly, and others indirectly.”

Brent crude, the international benchmark, has tumbled 41 percent since the end of June to $66.47 a barrel as U.S. output jumped to a three-decade high. The price today touched $65.29, the lowest since September 2009. The Bloomberg Commodity Index fell 12 percent this year. The MSCI All-Country World Index of equities gained 3 percent, while the Bloomberg Dollar Spot Index climbed 9.7 percent.

Consumer Benefit

Falling oil prices will be a boon to consumers who can expect to pay less for food, Citigroup’s Aakash Doshi said in a Dec. 3 report. About 45 percent of the operating expenses of growing and harvesting rice comes from inputs such as fuels, lubricants, electricity and fertilizer, according to a U.S. Energy Information Administration analysis of U.S. Department of Agriculture data. Energy accounts for about 54 percent of costs of corn and wheat.

Energy makes up 30 percent to 40 percent of operating costs for mining, according to Citigroup. The bank estimates that a further 20 percent drop for oil, along with gains for the dollar, would cut thermal-coal costs by $8 a ton, or 13 percent, and iron ore by $4 a ton, or about 6 percent.

Cereal maker Kellogg Co. expects “relatively benign” commodity inflation, Chief Financial Officer Ronald Dissinger said Oct. 30. The slump in oil will make some cotton fabric cheaper, Bryan Timm, chief operating officer of Columbia Sportswear Co., said on an Oct. 30 conference call.

Missing Out

Not all commodities will benefit from cheaper oil. While energy accounts for about 40 percent of the cost of making aluminum, most of that fuel is coal or hydro-electric power, which have little or no relationship with crude prices, SocGen’s Haigh said in a report last month.

This year’s oil slump may have come too late to benefit U.S. farmers. Growers usually buy tractor diesel, energy-based fertilizers and pesticides well before the harvests, which started in September for the biggest crops, corn and soybeans. That means prices will need to remain lower for months to reduce farming costs for next season, Michael Swanson, a Minneapolis-based senior agricultural economist at Wells Fargo Co., the biggest U.S. farm lender, said last month.

What’s happening in oil might be separate from other commodities, said David Rosenberg, the chief economist at Gluskin Sheff & Associates Inc. in Toronto. Crude is dropping because of too much supply, not because demand is weak, so better economic growth should mean buoyant consumption for other raw materials, he said.

OPEC’s Play

The 12-nation Organization of Petroleum Exporting Countries last month kept its output target unchanged even after the steepest slump in oil prices since the global recession. The fracking boom has sent U.S. output up 33 percent in the past two years to 9 million barrels a day, contributing to a global surplus that Venezuela on Nov. 27 estimated at 2 million barrels a day, more than the production of five OPEC members.

Cheaper oil impacts commodities in more ways than just reducing production costs. It’s also damping the outlook for rising consumer prices, eroding the appeal of gold and other assets used as inflation hedges, according to Jeff Sica, president of Sica Wealth Management LLC in Morristown, New Jersey.

Taming Inflation

Gold futures in New York dropped to $1,130.40 an ounce on Nov. 7, the lowest since 2010. U.S. inflation expectations, measured by the five-year Treasury break-even rate, fell 29 percent this year, set for the biggest decline since 2008.

Goldman Sachs Group Inc. cut its outlook for copper prices on Nov. 17, citing a strengthening dollar and falling input costs, including oil. The bank lowered its six-month outlook by 6.1 percent to $6,200 a metric ton. Prices today traded at $6,370.25. Energy accounts for about 18 percent of production costs, analysts led by Max Layton said.

Corn is the most directly affected agricultural commodity when oil prices fall, and lower costs could spur farmers to increase plantings, while reducing the appeal of biofuels made from the grain, Christopher Narayanan, a SocGen analyst, said in a Dec. 4 report. The bank expects prices to fall to an average $3.92 a bushel in 2015. Futures in Chicago have averaged about $4.20 this year.

“What you see in a farm is tractors, trucks, pumps, fertilizer and chemicals, so everything is somehow linked to energy,” said John Baffes, a senior economist at the World Bank in Washington. “If the decline in oil prices is sustained, or oil prices are even lower in the future, that will relieve a lot of pressure from agriculture.”